The Common Good: Debts, Deficits and Economic Growth

Published: Oct. 27, 2010

The old advice: “Keep your eye on the ball” makes sense when discussing the problems of the U.S. economy. We have become diverted from the immediate issue — jobs — to the issues of deficits and the national debt.

The claim that the national debt will bankrupt the country is a serious issue in the long term but not in the short term. The claim that it hinders the recovery by crowding out private investment is not important at this time. Private investors are not investing in new capital goods because there is insufficient demand for the output from those capital goods, not primarily because the federal government is out-competing the private sector for available savings.

However, there is one argument for making debt reduction a key issue NOW, and that is a psychological one. The argument goes something like this: Investment by business, particularly by small businesses, is driven by future profit expectations; large federal budget deficits increase uncertainty about the future stability of the economy. The result — businesses invest less and thus hire fewer workers. This, in turn, impedes the economy from recovering.

So what is needed is a firm sign that the debt problem will be addressed. If this is believed, businesses will be willing to invest and hire workers in the expectation that the future will be stable and prospects bright for future profits.

Unfortunately there is little undisputed empirical evidence to support this theory as a singular explanation for growth or the lack thereof. Ireland, for example, has pursued a deficit reduction program for the past two years and their economy has not improved at all. In fact it has declined farther than most, now averaging 13 percent unemployment. Despite this, a number of European countries are pushing for debt reduction now. The argument cannot be ignored and I will come back to it below.

The recession of the past three years has held back growth in income and therefore in tax revenues. The normal expectation is that there should be three or four years of better economic growth — enough to reduce the deficit significantly. But a problem persists. The economic stimulus of 2009 was too weak to kick start the economy into a growth path that would absorb the unemployed and provide jobs for new entrants to the labor force. And Congress is resisting any further stimulus on the grounds that it will make the deficit worse.

And so we face the undesirable prospect of a decade-long Japanese-style stagnation of growth and employment or even a double-dip recession.

The primary task at this time, therefore, is to provide further economic measures which will generate jobs and a growth in incomes that will result in increased tax receipts. This, in turn, will help reduce the deficit even though alone it will not be enough.

In the longer run — three to five years — attention will need to turn to the structural deficit problem (defined as a deficit at full employment). Continuing economic growth in the USA will require us to increase national savings (defined as personal + business + government + foreign savings) by reducing the chronic federal budget deficit (which is dis-savings), to finance private and public investment.

The approach to deficit reduction in the long term that relies on economic growth to increase tax revenues is faced with a chicken egg problem: economic growth is needed to lower the deficit, but the deficit needs to be reduced to insure long term economic growth. Though control of expenditures must make a contribution, neither spending cuts nor “natural” growth can of themselves eliminate the deficit.

It follows then that tax increases are also needed. In economic terms, the deficits resulting from tax cuts of the early 1980s and the early 2000s have lowered the total national savings available to finance long-term investment in the economy, the source of productivity gains and economic growth. The continuous deficits over the past four decades (except for the last years of the Clinton Administration) have forced a reliance on foreign savings for domestic investment resulting in increasing trade deficits.

Deficit reduction is not the number one problem at this time. Creating jobs is. But it is a serious problem for the long term. Thus, the Obama administration should signal now that it is thinking and planning how best to reduce the deficit when the time comes to do so. And it is here where our values are crucial in making choices regarding the necessary tax increases and expenditure reductions.

Charles K. Wilber is a Notre Dame professor emeritus of economics and fellow of the Kellogg Institute for International Studies who has written widely on Catholic social thought and economic theory. Email him atcwilber@nd.edu.